Invest in Stocks to Take Advantage of Positive Economic Developments

The S&P stock index has returned 10.2% annually for the past three years.

Since the financial crisis began, investors have been dumping stocks and shifting to bonds. In the past year alone, shareholders have pulled $120 billion out of stock mutual funds and deposited $235 billion into bond funds, according to Morningstar.

So far, however, it appears that investors who abandoned stocks have made a mistake. During the past three years, the Standard & Poor's 500-stock index has returned 10.2% annually, while the Barclays Capital Aggregate bond index only returned 5.7%. Can stocks continue delivering decent long-term returns? Many analysts argue that the markets can produce at least single-digit results in the coming years. So investors should continue holding stocks.

The exodus from stocks was triggered by the turmoil of the financial crisis. With the financial system about to collapse, stocks around the world fell sharply. The steep losses came at a time when memories were still fresh of the market downturn that occurred after the Internet bubble burst in 2000.

Irrational conclusions

While they may have had cause to be wary, many investors have panicked and drawn irrational conclusions about how bad the downturns were. Consider a recent study of investor perceptions done by Franklin Templeton, a mutual fund company. The study found that investors had an unduly negative view of the market returns. In 2009, the S&P 500 returned 26.5%, but 66% of investors in the survey thought that the market had lost money that year. In 2010, the S&P gained 15.1%, but 49% of those in the survey believed that stocks declined.

Figuring that stocks have returned nothing in recent years, many investors now talk about a “lost decade.” In fact, there was a brief time at the trough of the downturn when the 10-year returns were close to zero. Since then, the picture has improved. During the past decade, the S&P stocks returned 6.7% annually. During the past 15 years, the returns were 4.5%.

Now many analysts argue that stocks will do as well in the future as they have done in recent past. One of the foremost bulls is John Bogle, founder of Vanguard Group. Bogle relies on a simple system for his predictions. He starts by looking at the dividend yield of the S&P 500. The current figure is 2%. So that is the return that investors will receive if they just collect dividends and don't benefit from any share price appreciation. Bogle also considers the average historical growth in corporate earnings, which is about 5% to 6% annually. Stock prices tend to rise along with earnings gains, he says. Adding dividends and earnings growth, he predicts that stocks will return 7% to 8% annually over the next 10 years.

Cynics may scoff at Bogle's simple method, but his forecasts have proved remarkably accurate over the decades. In the 1990s, Bogle predicted that markets would deliver double-digit returns—a forecast that proved accurate. In 2000, he correctly warned investors to expect modest results.

Inflation erodes bond results

Investors who are clinging to bonds should note Bogle's prediction that Treasury bonds will return 2% to 3% annually in the next 10 years. According to his thinking, the return of bonds is equal to the interest that they pay. In today's market, 10-year Treasuries yield 1.6%, while 30-year issues yield 2.7%. Bond results will be especially unsatisfying because inflation erodes the purchasing power of interest payments. Inflation is currently running at an annual rate of 2%. If that continues for the next decade, bond investors would see no after-inflation gain in their assets.

Another analyst who favors stocks is Michael Roberge, president of MFS Investment Management, a mutual fund company. Roberge says that investors have been frightened by reports about a variety of problems, including the European financial crisis and troubled U.S. housing markets. He concedes that these concerns could explode and take down the markets. But he argues that the odds are good that the backdrop for the markets will improve markedly in the next decade.

For starters, the housing market is poised to recover. After several years when few people bought houses, there is a huge amount of pent-up demand. Now that the economy is stabilizing, sales of houses are climbing. That trend is likely to continue since prices have dropped to the point where many buyers can afford to make the purchases that had been postponed.

Outlook improving in Europe

The outlook in Europe is also improving. In recent years, debt problems in Greece and other countries pushed Europe into recession. That hurt export sales of U.S. goods. Now Germany and other countries have begun stepping forward to support their troubled allies. That should prevent a collapse and enable Europe to begin growing again within the next year. The improvements in Europe should help to prop up U.S. stocks during the next decade.

To take advantage of the positive economic developments, most investors should hold sizable stakes in stocks. If you do not need to tap holdings for ten years or longer, consider putting at least 50% of your assets in stocks. To avoid disappointment, stick with rock-solid companies or funds that hold blue chips. A reliable fund is Jensen Quality Growth. During 2008, the fund outdid 98% of its competitors. The Jensen portfolio managers only take companies that have reported strong profits for ten years in a row. Holdings include such familiar names as PepsiCo, 3M, and Microsoft. Those blue chips should continue delivering solid returns in up and down markets.